View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Economic Policies fo r a Post Cold w ar Environment

Jerry L. Jordan
President and Chief Executive Officer
Federal Reserve Bank of Cleveland

Address delivered to the
European Forum
Alpbach, Austria
August 31,1993



(dictation o f speech given in Alpbach)
(following is a working d raft fo r subsequent speech)

August is my favorite month of th e year. That is because our
President is on holiday, our Congress is in recess, and fo r the m om ent, at
least, our liberties are secure. But I always look forw ard with some
uneasiness to the arrival of September because th e politicians will be
returning to office, and one can never be sure w hat is going to happen.
August is a good tim e to hold th e Alpbach Conference because,
w ith elected leaders generally around the world on holiday, the nations'
capitals are not generating any news so it's interesting to look at those
issues th a t are in fact dominating the mass media.

August gives you a

chance to reflect on the major issues th at are of a more fundam ental
nature than the pronouncements of politicians.
I think a very interesting history o f the second half of th e 20th
century could be w ritten by simply focusing on the top news stories
during th e tim e of the Alpbach Symposium, in recent years, fo r instance,
th ere have been some very profound developments while you have been
m eeting here. Four years ago, you would have been focusing on the
flood o f European refugees coming out of Hungary and East Germany,

through Austria, into the West -- people voting with their fe e t about
socialism and communism, in August of 1989, you could not have been
sure w hat th e implications were going to be, w hat the response of the
Soviet union m ight be, or how the Western countries would react.
Three years ago, you would have all been focused on the
occupation of Kuwait by Saddam Hussein -- wondering about the
implications of his dominating a large share of the Persian Gulf oil
resources, and the possible response of the Western Allies.
Two years ago, you all would have been discussing the
developments in the Soviet Union as a group of bungling thugs took
Mikhail Gorbachev prisoner, while Boris Yeltsin stood on top of a tank
defying th e a tte m p t coup. And, this year, we see th at millions o f young
people around the world are drawn together in solidarity focused on the
continuing crisis of allegations regarding Michael Jackson.
While this latter may sound as though it is not in the same category
w ith prior years, it may be just as significant, if this is all th at the world
has to w orry about at th e moment, we're in p retty good shape. I can
assure you that, at least fo r young people around the world, the break-up
of th e European Exchange Rate Mechanism, or the recent rise of the Yen,
are not th e dom inant issues of 1993.
While listening to yesterday's discussion, I found the various
interpretations of the meaning of autonomy and integration to be of

in terest To some it appears th at autonomy means insulation from the
policies of others. People talk about independent Central Banks, but it
leaves me wondering -■ independent to do what? -- independent from
what? in the Federal Reserve System, it has become commonplace to say
th at our Central Bank is independent within the governm ent, not
independent o f th e governm ent.
I was intrigued yesterday by one of the discussions about the
economic integration o f Europe requiring greater independence of the
Central Bank, but then interdependence of the economies reduces the
autonom y o f the governm ent. So, we have the paradox th at greater
independence or autonom y of th e Central Bank is essential fo r
integration which, in turn, reduces autonomy of, I suppose, other parts of
the governments. W hat none of this discussion raises is the autonom y of
individuals to make th eir own decisions.
Even though we talk about the Federal Reserve being independent,
th e Bundesbank, th e Bank of New Zealand, or other central Banks th at are
moving toward independence, it is independence only in a certain
manner of speaking, in contrast to th at notion, increasingly we are
seeing th a t th e globalization of financial markets means th at even the
m onetary policy actions of the United States are disciplined by the
financial market vigilantes in the equity, debt and foreign exchange
markets. One only has to look at 1987, when 28 stock markets around the

world crashed, to realize th at the economic policies of the major
industrialized market economies are not at all independent of each other.
Once upon a tim e, it was said th at when the United States sneezes,

Europe catches pneumonia. But, th a t’s no longer true. Now, the first
thing th a t w e w ant to know in the U.S., early in the day, is w hat
happened earlier the same day in Tokyo and then later in Frankfurt, Paris,
London, Rome and other major financial centers in Europe before moving
on to New York. The interdependence of financial markets means th a t
some of th e so-called independence does not exist.
When the word integration appears as a topic of discussion, from a
U.S. perspective the first thing one thinks about is racial issues. Since at
least th e 1960s th e word integration has always been juxtaposed against
the word segregation -- meaning, racial divisions. That certainly is not
w hat you're talking about here, but it has not been fully clear to me yet
w hat it means on the program. So, I'm going to give you my view of
w hat m ight be meant by some of these terms.
I've subtitled my paper, Economic Forces and Political institutions.
and i need to spend a fe w minutes defining these terms. While I know
th at th ere have been many forces at work over the 20th century -­
certainly political, social and religious forces have helped shape the
course o f events fo r these hundred years -■ I'm going to focus only on
those th a t I call "economic forces". These include technological changes

or innovations; productivity increases; lower information, transactions,
transportation and communications costs; the phenomenon sometimes
referred to as downsizing; and, of special note, as the century draws to a
close, th e true value added rising from knowledge-based industries as
opposed to resource exploitation activities.
in the I9th century and at the beginning of the 20th century, w e
tended to measure th e wealth of nations by tons of things and numbers
of things. Basically, iron ore, coal, the numbers of logs cut, tons of
wheat, and so on, all tended to be added up to make a statem ent about
the so-called output or wealth of countries.

But, th at is no longer

appropriate, instead, in today's world those things produced by
companies such as Microsoft, the world's leader in software, and other
human capital-enhancing enterprises are more im portant in determ ining
th e relative well-being of nations, in fact, we see some of th e most
natural resources, or raw material, rich places in the world -- such as
Brazil, Russia, and Africa -- are actually economic basketcases, while the
natural resources poor places of the world sometimes are among the
most prosperous.
Let me turn now to political institutions. I'm going to define tw o
d ifferen t types because of the different ways we use the word
institutions. First, is organizations, such as ministries, bureaus,
departm ents, agencies, and central banks -- as well as international

organizations, such as the IMF, the w orld Bank, and the Bank fo r
international Settlements. Even the united Nations and NATO could be
put into this type of grouping. The second way we use the word political

institutions is rules -- meaning contracts, generally accepted accounting
practice, labor laws, laws of incorporations, the judicial system and the
enforcem ent of property rights. Rules also includes various types of
economic controls, such as wage, price, credit, interest rate, exchange,
and capital controls, or even margin requirements. One would also take
into account such restrictions on the financial industries such as loan-loss
reserves, capital adequacy standards, debt limitations, credit allocations,
leverage ratios, and so on.
Some of both of these types of institutions -- the organizations th at
are created and th e rules th at are laid down -- are intended to improve
th e workings o f markets. However, some of both types of institutions -­
organizations and rules -- are also intended to inhibit or alter the working
o f markets because the benefits are perceived to be greater than the
cost. That is the case when political social objectives seem to dom inate
economic efficiency. Such objectives as redistribution -- a political
decision to give priority to sharing wealth, rather than creating wealth -­
result in institutional arrangements th at reduce the efficiency of markets.
I'm going to argue th at some of w hat I call economic forces
constitute an irresistible force, while some o f the political institutions

tend, over time, to become immovable objects. Even those political
institutions th at are intended to improve the workings of markets and
are designed to have a great deal of inherent flexibility or adaptability,
tend to become immovable objects. A conjecture is th at th e degree to
which political institutions tend to become immovable objects depends
on th e scope of governm ent involvement in the economy. The size of
governm ent, measured in terms of governm ent spending as a percent of
GDP, may reflect the scope of governm ent involvement in resource
allocation and control, but it is not sufficient as a complete measure of
intrusion of governm ent in the economy.
in a pure m arket economy, there would be no institutions th a t w e
would call immovable objects. On the other hand, in a total command
economy, all institutions would take on the characteristics of immovable
objects. However, they would prove not to be immovable a fte r all in the
face o f th e irresistible economic forces in a global economy.
The architects o f new rules or organizations usually understand the
need to create institutions th at are "living organisms" capable o f adapting
to changing conditions. This is true not only of constitutions fo r
governing, but also of the various agencies of governm ent w ith specific
The Bretton woods System established in the final days of w orld
w a r ll had built into it rules fo r adjustment. However, there was an

asymmetry in the way the rules worked that proved to be the rigidity
that caused the system to break, rather than bend, in the face of specific
economic forces.
Much o f the history of the 20th century reflects w hat I think o f as
the "contest of ideas" -- democracy and capitalism on one hand locked in
a struggled w ith dictatorship and socialism. Essentially, it was a contest
fo r the minds of the people of the world as to the best ways to organize
economic affairs and th e best ways to organize political affairs.
in many respects, especially from a U.S. standpoint, there w ere tw o
watershed decades o f the century the 1930s and the 1980s. in the 1930s,
during the world-wide economic depression, there was a massive increase
in the intrusion of governm ent in economic affairs, if governments did
not outright nationalize and directly control resources in a command
structure, then they set up regulatory agencies th at w ere designed to
decide w h at was to be produced, w here it was produced, how much
could be charged fo r products, how much could be paid to workers, or
fo r o ther inputs to production, w hat interest rates could be charged,
w hat interest rates could be paid, and so on.
The subsequent several decades after the 1930s w ere a period in
which th e role of the nation-state in economic affairs was large and
tending to grow. Much of the underlying conceptual fram ew ork was
based on w hat I think of as the "stagnation thesis" as set forth in


John Maynard Keynes in The General Theory in the 30s. That is, even
economies th at are based on private property and rely on market forces
to allocate productive resources, tend to stagnate at less than full
potential in the absence of governmental activities to cause growth, in
other words, a view widely held through much of the 20th century, and
maybe even continues to be held today by a lot of people, is th at
governments cause growth, and the so-called economic "policies" of
governm ent are appropriate fo r influencing economic activity.
The rival conjecture from the 1930s, which had little following fo r
most of this century, was the "inherent resiliency proposition" of
Friedrich A. von Hayek and other economists of the Austrian school. Their
view was th a t an economy th at relies on a price system to allocate
resources in a market environment, relying on private property rights,
tends to be inherently resilient -- th at is, it naturally gravitates toward full
utilization o f its productive resources in absence of governm ent pump
priming. W henever shocks of various types -■ such as oil price increases,
droughts, wars, or perverse governm ent policies -- knock the economy
down, th ere is a general tendency to start to grow again as th e perverse
effects o f these negative shocks tend to dissipate.
Common threads o f the contest of ideas in th e 20th century have
been: (1) That political and economic institutions tend to "ossify" or to
"rigidify" over time, mainly because these institutions, especially

organizations created by people and operated by people, become
resistant to changes of the status quo; (2) The fundam ental economic
forces -- technological innovation, falling information and transaction
costs, increasing economies of scale and economies of scope of
production, globalization of goods markets, financial markets, and asset
markets -- all lead to w hat is called the "global village" or "borderless
world". One recent book was titled the "Tw ilight o f sovereignty.”
The main thesis is th a t while the naturally efficient marketplace fo r
many goods and services at the beginning of the 20th century was a small
town, village, or a province, increasingly, over the course of the century,
the grow th in the naturally efficient market expanded to the point th a t
even large countries such as the United States find it increasingly difficult
to regulate or control various products or services. That is because fo r
many products and services the entire world has become the naturally
efficient market, so the ability to regulate or control depends on the
ability o f th e nation-states to collude in common regulation. The
Basle Accord o f 12 countries getting together to set capital standards fo r
commercial banks is one example of this. Possibly the developm ent of
th e European com m unity is a similar effort.
The ultim ate implication of the conflict between the irresistible
forces th a t o f an economic nature, confronting the political institutions
th a t take on th e characteristics of immovable objects, is th at institutions


must change, or they will fail, in other words, there must be an effective
political and economic regeneration in which various institutional
arrangements, especially organizations, take on the characteristics of

living organisms -- th at is, they must be adaptable to a changing
Joseph Schumpeter, another Austrian economist, said "the essential
point to grasp is th at in dealing w ith capitalism we are dealing w ith an
evolutionary process. . . Capitalism, then, is by nature, a form or m ethod,
of economic change and not only never is, but never can be, stationary."
Schumpeter's observation about capitalism applies equally well to all
of the institutions th at define the parameters of our global economy.
Propelled by technological change and chance economic events, these
institutions undergo a continual process of change. Those qualities th at
enhance economic well-being tend to survive, and those th a t do not
eventually disappear, people develop institutions -- laws, rules,
conventions, and customs, to define and enforce property rights and,
m ore generally, to reduce the costs of economic exchange. The various
laws, rules, conventions, and customs th at define money, protect its
purchasing power, and govern its use, are example of such institutions.
Recent international m onetary developments can be explained in
term s o f these general ideas about institutional transformation. What
appears as conflicts between global monetary integration and regional

-11 -

monetary autonom y are artificial, resulting largely from vested interests
in maintaining local governmental monopolies over the issuance of the
national media of exchange. History demonstrates, however, th at
national currencies inevitably compete in the international financial

Earlier in this century, the U.S. dollar gradually replaced th e British

pound as the dom inant global reserve currency and as the primary unit
of account fo r international transactions. Following Hayek, approaches to
international m onetary relations th at foster com petition among
alternative currency units are more likely to enhance world welfare than
systems like Bretton woods th at mandate change directed by
supranational governmental bodies which will tend to rigidify or ossify
over tim e.
unlike most people, economists think of money as m erely an
institutional convenience fo r greatly reducing the costs of transacting.
Overall, a stable monetary unit allows greater specialization in production
and w ider choices in trade, thus, enhancing the associated economic
Building on these ideas, many economists and political scientists
contend th a t extending the geographical area in which a common
m onetary unit is used would confer significant gains on the residents of
th a t area. Monetary integration can take tw o institutional forms: The
first is com plete m onetary union w ith a common currency and a single


Central Bank. This is already the case among the 50 united States and
among th e 10 provinces of Canada. And, it is the ultim ate objective of
the European Monetary Union.
A second and weaker form of monetary integration is fixedexchange rates, such as experienced under the gold standard or the
Bretton woods System, as well, of course, as under the European
Exchange Rate Mechanism. The conditions under which th e second form
is viable needs to be addressed.
Although a system of fixed-exchange rates could confer significant
benefits on participants in terms of reduced transaction costs, it also
imposes specific costs in terms of international cooperation and
macroeconomic policy coordination. The external value o f a national
currency ultimately reflects the relative internal purchasing pow er of th at
currency. So, to maintain an exchange-rate, participants must coordinate
their m onetary policies to generate the same inflation rates. Monetary
sovereignty is incompatible with fixed-exchange rates. This is why
inflation convergence is so crucial.
Under certain circumstances, however, the costs of integrating
m onetary policies across countries can exceed the benefits of having a
common currency. Countries are most likely to form a m onetary union
w ith o th er countries th a t share common economic conditions. To
understand th e macroeconomic sources of the conflict, consider the

-13 -


history of the Bretton woods System.
The Allies established Bretton woods in 1944 to prom ote rapid
recovery among war-torn economies. Close cooperation was seen as
necessary to avoid the com petitive devaluations and trade restrictions of
the 1930s, which many economists believe contributed to the severity of
the Great Depression.
in th e late 1940s, Germany and Japan fo r instance, had a common
unit of account, or standard of value -- it was called the United States
dollar. However, they gave it a different name, in Germany, one quarter
of the U.S. dollar was called a Deutsche mark and in Japan, one three
hundred and sixtieth of a dollar was called a Yen. The point is th a t the
standard o f value or unit o f account was not the same as th e media of
exchange. The latter are created or issued by governmental authorities,
but the fo rm er is the crucial dimension of a currency. There never has
been a Phoenix-like currency th at arose from nowhere, unlinked to
anything o f accepted value.
The Bretton Woods System required all participating countries to
define a parity fo r their currency against the dollar and to maintain the
resulting fixed-dollar exchange rate. The United States, as the "anchor", or
"key", currency, defined and maintained a dollar peg to a fixed quantity
o f gold. The dollar then functioned as a stable unit of account fo r the
entire Bretton woods System. The rules of the game required all

-14 -

countries to adopt a m onetary policy similar to th at of th e united States,
in other words, the Bretton Woods System implied reduced m onetary
autonomy fo r participating countries.
My review of macroeconomic factors suggests th at m onetary
integration is more likely to be successful if: (1) All regions in a m onetary
union have similar preferences for inflation, reflecting similar theoretical
or conceptual views of m onetary policy, and (2) All regions within a
m onetary union experience similar macroeconomic conditions.
While common responses to macroeconomic shocks are a desirable
condition to enhance the likely success of monetary integration, they are
not necessary. Regions o f th e United States often experience d ifferen t
macroeconomic conditions, especially responses to shocks such as energyprice changes, defense spending increases or decreases, and so on. W hat
is crucial is th a t other avenues fo r adjustment between regions are
available, so th a t exchange rate changes are not the issue, in the 1980s,
w e had w hat was called a bi-coastal economy, referring to boom
conditions in California and New England while we had depressed
conditions through much o f the middle part of the country. Now, in the
early 1990s, w e once again have a bi-coastal economy w ith th e opposite
implications. Namely, we have severely depressed economic conditions in
California and a continuing recession in New England, while the Rocky
Mountains and th e midwest are by comparison considerably stronger, if


it w ere not fo r the political integration and the associated high degree o f
resource mobility (investible capital resources as well as labor resources)
then it would be more tem pting fo r various regions within the United
States to contem plate devaluation of their currencies in today's
environm ent. The severe three-year old recession in California m ight lead
some to believe th a t devaluing the California dollar vs. th e Ohio dollar, or
th e Rocky Mountain dollar would be an attractive option. But, because of
th e political unity and resource mobility, this option is not under
The recent history of our global monetary systems suggests th at
attem pts to impose m onetary integration by a fixed-exchange rate on a
broad scale are not likely to succeed, in part, as I've argued, this results
because regions o f th e world th at experience disparate economic
conditions and low resource m obility can adjust to economic shocks more
efficiently by allowing their exchange rates to change. Furthermore,
m onetary integration cannot proceed in a credible manner, even among
regions in which it is feasible, unless governments first adopt domestic
institutions th at credibly insure their com m ent to maintain domestic
price stability.
History teaches us th at institutions, including those th a t determ ine
the use of national currencies, inevitably compete. Through com petition,
efficient wealth enhancing institutional forms tend to emerge, in the


interest o f fostering greater international stability and integration, we
should encourage such institutional competition. This requires, above all
else, th e free m ovem ent o f resources through the elimination o f artificial
restraints on the m ovem ent of capital, goods, services, and labor. This
could include the removal of either national legal tenure laws so th at
individuals could be assured of enforcem ent of contracts w ritten in any
currency. More likely, we could urge th at the various parliaments legislate
"specific performance" so th at the courts will enforce contracts
denom inated any currency units. This would enhance the rule o f law
across borders of nation-states.
individuals would then hold their assets in currency units th a t are
most stable in terms of their expected long-term purchasing power. A
free flo w o f resources would foster a convergence of institutional forms
across participating governments as they com pete fo r these resources by
providing stable economic and political environments. Governments th at
fail to provide such an environm ent will lose resources as markets vote on
policies. The resulting convergence of monetary and fiscal regimes will
achieve th e highest sustainable degree of monetary stability.
When some observers look at the centrifugal and centripetal forces
at w ork in various regions of the world, there seems to be a conflict.
That is, when one looks at the efforts under way to achieve European
com m unity objectives -- economic integration, and, maybe ultimately

-17 -

political integration among twelve or more European nations - in
contrast w ith the political and economic disintegration of th e fo rm er
Soviet union, it m ight appear that these trends are going in opposite
directions. I do not think th at that is the case. The common elem ent in
both developments is that, in the case of Europe, the move toward
political and economic integration involves a very large num ber of
specific steps to reduce th e role of the participating nation-states in the
economic affairs, in o ther words, it consists of specific actions to
improve th e workings o f th e markets within Europe - to strengthen
property rights within Europe and to eliminate a whole host of rules,
regulations, barriers, and obstacles to the free mobility of goods, labor,
and capital.
in th e fo rm er Soviet Union, we see th at political and economic
disintegration is a process of tearing down the highly centralized
command and control socialist economy. It is a process o f searching fo r
ways to make markets flourish in the 15 or so republics of the fo rm er
Soviet Union, as well as in the eastern European countries of the fo rm er
COMICON. So, the move towards economic/political integration in Europe
and disintegration in the fo rm er Soviet bloc both involve the tearing
down o f previously erected political institutional arrangements th at
interfered w ith the workings of markets.
in this final decade of the 20th century, it seems th at th e clearest


trend around the world is to reduce the role of the nation-state in
economic affairs. Deregulation and denationalization/privatization and
tax reduction and tax reform, are all part of a process of "economic
regeneration" -- to once again restore the wealth creating capability of
markets. Resources, especially investment capital, move quickly to those
regions th a t are making the most progress such as today in Mexico,
Argentina, or the Czech republic -- while resources move away from those
regions making little or no progress. This competition of political
institutions -- both of the organization type and the rules type -- is a part
of w hat l view as a very healthy process of reinstituting 19th century
economic liberalization. The end result of it will be a much freer, as well
as a much more prosperous world. The ultimate autonom y is not th at of
nation-states, th at of individuals. The goal of "economic integration"
should be to create institutions in which individuals are "free to choose."